FM2555

Corporate
Finance
How to Calculate Present Values

CHAPTER 2

1-2
 Topics Covered
• Future Values and Present Values
• Looking for Shortcuts—Perpetuities and Annuities
• More Shortcuts—Growing Perpetuities and Annuities
• How Interest Is Paid and Quoted

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 Present Value and Future Value

Present Value
Value today of a
future cash flow.
Future Value
Amount to which
an investment will
grow after earning
interest
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Future Values

Future Value of $100 = FV

t
FV $100 (1  r)

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 Future Values

t
FV $100 (1  r)
Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 7% for two
years?
FV $100 (1.07) (1.07) 114 .49
FV $100 (1  .07) 2 $114 .49

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 Future Values with
Compounding
1800
1600
0% 5% 10%
1400 15%
1200
Interest Rates
FV of $100

1000
800
600
400
200
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Number of Years
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Present Value

Present value = PV

PV = discount factor C1

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 Present Value

Discount factor = DF = PV of $1

DF  1
(1 r ) t

Discount factors can be used to compute the

present value of any cash flow

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 Present Value
• The PV formula has many applications. Given any
variables in the equation, you can solve for the
remaining variable. Also, you can reverse the prior
example.

PV DF2 C2
PV  (1.107 ) 2 114 .49 100

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 Present Values with
Compounding

120

100
Interest Rates
80 0% 5% 10%
PV of $100

15%
60

40

20

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Number of Years
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 Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = C0 = 700,000
Sale price in Year 1 = C1 = 800,000

Step 2: Estimate opportunity cost of capital

If equally risky investments in the capital market
offer a return of 7%, then
Cost of capital = r = 7%

1-12
 Valuing an Office Building

Step 3: Discount future cash flows

C1 800 , 000
PV  (1r )  (1.07 ) 747,664
Step 4: Go ahead if PV of payoff exceeds investment

NPV 747,664  700 ,000

47,664
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Net Present Value

NPV = PV - required investment

C1
NPV = C0 
1 r

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 Risk and Present Value
• Higher risk projects require a higher rate of return
• Higher required rates of return cause lower PVs

PV of C1 $800,000 at 7%
800,000
PV  747,664
1  .07

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 Risk and Present Value

PV of C1 $800,000 at 12%
800,000
PV  714,286
1  .12

PV of C1 $800,000 at 7%
800,000
PV  747,664
1  .07
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Risk and Net Present Value

NPV = PV - required investment

NPV = 714,286 - 700,000

$14,286

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 Net Present Value Rule

• Accept investments that have positive net present

value
Example
Use the original example. Should we accept
the project given a 10% expected return?

800,000
NPV = -700,000 + $27,273
1.10
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 Rate of Return Rule

• Accept investments that offer rates of return in

excess of their opportunity cost of capital

Example
In the project listed below, the foregone
investment opportunity is 12%. Should we
do the project?
profit 800,000  700,000
Return   .143 or 14.3%
investment 700,000

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 Multiple Cash Flows

For multiple periods we have the discounted cash flow (DCF)

formula

C1 C2 Ct
PV0  (1r )1  (1r ) 2  ....  (1r )t

T
NPV0 C0   (1r )t Ct

t 1

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 Net Present Values

$30,000 $ 870,000

Present value Year

0 1 2
Year 0
-$700,000
30,000/1.12 = $26,786
870,000/1.122 = $693,559
Total = $20,344

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 Shortcuts

• Sometimes there are shortcuts that make it very

easy to calculate the present value of an asset
that pays off in different periods. These tools
allow us to cut through the calculations quickly.

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 Shortcuts

Perpetuity - Financial concept in which a cash flow is

theoretically received forever.

cash flow
Return 
present value
C
r
PV
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 Shortcuts

Perpetuity - Financial concept in which a cash flow is

theoretically received forever. (NOTE: annuity in the
context of the textbook is an immediate annuity – i.e.
the first cash flow is one period from today)

cash flow
PV of cash flow 
discount rate
C1
PV0 
r
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 Present Values

Example
What is the present value of $1 billion every
year, for all eternity, if you estimate the
perpetual discount rate to be 10%?

PV  $1 bil
0.10 $10 billion

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 Present Values

Example - continued
What if the investment does not start making
money for 3 years?

PV  $1 bil
0.10
 
 1.10
1
3 $7.51 billion

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 How to Value Annuities

Annuity - An asset that pays a fixed sum each year for a

specified number of years (NOTE: annuity in the
context of the textbook is an immediate annuity – i.e.
the first cash flow is one period from today)

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 Perpetuities & Annuities

PV Annuity Factor (PVAF) - The present value of $1 a

year for each of t years

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 Costing an Installment
Plan
Example
Tiburon Autos offers you “easy payments” of $5,000 per year, at the
end of each year for 5 years. If interest rates are 7%, per year, what is
the cost of the car?
5,000 5,000 5,000 5,000 5,000
Year
Present Value 0 1 2 3 4 5
at year 0
5,000 / 1.07 4,673
5,000 / 1.07  4,367
2

5,000 / 1.07  4,081

3

5,000 / 1.07  3,814

4

5,000 / 1.07  3,565

5

Total NPV 20,501

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 Winning Big at the Lottery

Example
The state lottery advertises a jackpot prize of $590.5
million, paid in 30 installments over 30 years of
$19.683 million per year, at the end of each year. If
interest rates are 3.6% what is the true value of the
lottery prize?

Would interest rates need to be higher or lower to make

the true value of the lottery prize equal to $590.5?

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 Annuity Due

Annuity due - Level stream of cash flows starting immediately

How does it differ from an ordinary annuity?

PVAnnuity due PVAnnuity (1  r )

How does the future value differ from an ordinary annuity?

FVAnnuity due FVAnnuity (1  r )

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 Annuities Due: Example

FVAD FVAnnuity (1  r )

Example: Suppose you invest $429.59 annually at
the beginning of each year at 10% interest. After 50
years, how much would your investment be worth?

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 Paying Off a Bank Loan

Example - Annuity
You are purchasing a TV for $1,000. You are scheduled
to make 4 annual installments. Given a rate of interest
of 10%, what is the annual payment?

$1,000 = PMT  .10

1
  1
.10 (1.10 ) 4

PMT $315.47

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 FV Annuity Short Cut

Future Value of an Annuity – The future value of an asset

that pays a fixed sum each year for a specified number of
years.

 1  r   1 t
FV of annuity C  
 r 

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 FV Annuity Short Cut

Example
What is the future value of $20,000 paid at the end of
each of the following 5 years, assuming your
investment returns 8% per year?

 1  .085  1
FV 20,000  
 .08 
$117 ,332

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Constant Growth
Perpetuity

C1
PV0 
r g

g = the annual growth rate of the cash flow

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 Constant Growth
Perpetuity

NOTE: This formula can be

used to value a perpetuity
at any point in time.

C t 1
PV0 
C1 PVt 
r g r g

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 Constant Growth Perpetuity

Example
What is the present value of $1 billion paid at the end
of every year in perpetuity, assuming a rate of return
of 10% and a constant growth rate of 4%?

1
PV0 
.10  .04
$16.667 billion

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 Effective Interest Rates

Effective Annual Interest Rate - Interest rate

that is annualized using compound interest

Annual Percentage Rate - Interest rate that

is annualized using simple interest

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 EAR & APR Calculations

Annual Percentage Rate (APR):

APR MR 12

Effective Annual Interest Rate (EAR):
12
EAR (1  MR )  1

*where MR = monthly interest rate

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 Effective Interest Rates

Example:
Given a monthly rate of 1%, what is the
effective annual rate (EAR)? What is the
annual percentage rate (APR)?

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 Effective Interest Rates

Example:
Given a monthly rate of 1%, what is the
effective annual rate (EAR)? What is the
annual percentage rate (APR)?

12
EAR = (1 + .01) -1 = r
EAR = (1 + .01)12 -1 = .1268 or 12.68%

APR = .01 12 = .12 or 12.00%

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